Return on equity is the ratio that to use to measure the performance that an entity could generate over the period to its total shareholders’ equity. This ratio uses the bottom line of the entity over the period compared to averages total shareholders’ equity.
The good or bad ratio is depending on the requirement rate, previous period, and industry averages. A high ratio means high return, and a low ratio means less return.
In this article, we will talk about the five areas that we could use to five of our return on equity ratio.
The following is the formula that we will fix our ratio and it is very important to know not only how the ratio works, but also need to know how each item that we used are affected.
Formula = Net Income/ Shareholders’ Equity
The two important items in this formula are Net income and total shareholders’ equity or averages equity.
- Net income is basically the bottom line in the income statement, and before arriving this line, there are many items that we need to know. For example, sales revenues, cost of goods sold, gross profit, operating expenses, and other non-operating expenses like interest expenses, and tax. Net income is what the entity earned and will return to shareholders.
- Return on equity that use to calculate this ratio is including all equity items. And for easy to calculate, we can use the accounting equation to find out. That mean assets = liabilities + equity. Increase or decrease equity will also increase or decrease the ratio.
Now let see the five areas we could fix to increase or decrease return on equity ratio to the rate we need.
6 areas that you can use to increase or decrease ROE ratio:
1) Improve your financial leverage
Financial leverage is referred to as the entity’s policies on using the fund for its operation. Sometime the entity might use 50% debt and 50% equity fund. Or sometime, the entity might use other methods.
In some cases, the entity might prefer obtaining the debt to fund its operation rather than obtaining an equity fund.
In this case, total equities are small and the ratio will improve accordingly. However, we have to remember that using the loan to support operation, the entity will need to pay interest and principal back and it might face a cash flow problem.
2) Improve profits margin
The better the profit margin, the better net income and subsequently improve return to equity ratio. An increase in profit margin is very important for the ratio and it improves when the entity could improve production systems and well as costing system of the entity.
High productivity could lead to lower products cost and it will subsequently increase the margin. This margin could improve does not necessarily increase the number of sales unit, but it could improve by increased selling prices.
However, in the market where products are highly competitive, the entity could not increase the selling price.
The only room that they could improve is reducing costs by producing more products, buying low-cost material, hiring low labor costs.
3) Net profit margin
The increasing net profit margin will directly increase that return on equity ratio. And we can improve its base for two reasons. First, the gross profit margin is already improved.
That means if the gross profit margin improves and even the operating expenses remain the same, the net profit still improves. Second is improving net profit by improving operating expenses. Every single dollar of operating profit margin improve, do so net profit increase.
4) Improve asset turnover
Improve asset turn over could also help the entity to improve return on equity. For example, if the assets turn over is high that mean assets are effectively used or in other words, assets produce a good quantity of products with a high amount.
Improve assets turn over will improve both gross profit margin as well as net profit margin since the cost of products are low while the price could increase due to the quality of products.
5) Manage idle cash
Cash and cash flow management are quite important as it not only help an entity to solve its cash flow problem, but it also helps the entity to improve net income as well as reduce equity.
The entity could improve net income by pay off part or all of debt and then it will subsequently reduce the interest expenses. This will be a positive effect on net income and improve the ratio.
The entity could also use the idle cash to buy back some shares to that the equity will reduce and subsequently affect the ratio.
6) Tax expenses
Tax expenses are normally a large number of expenses in most of the entity and having the right strategy to reduce the tax expenses is quite important for the success of the entity.
There are many ways to reduce tax, for example, perform tax planning by making sure that the entity pays less tax but still compliance with tax law. This was normally done by hiring a tax consultant from professional firms.
The entity could also save tax expenses setting up the proper transfer pricing strategy as well as production diversity. For example, relocate the factory to the country where labor costs are low with a good tax incentive.
Above are the areas that you could use to improve your return on equity ratio. You could also use those areas to drop your return on equity if you need to.